IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we
inform you that any U.S. federal tax advice contained in this communication (including any attachments) is
not intended or written to be used or relied upon, and cannot be used or relied upon, for the purpose of (i)
avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to
another party any transaction or matter addressed herein. If you are not the original addressee of this
communication, you should seek advice based on your particular circumstances from an independent adviser.
1) Exchange of Partnership Interest
a) The Tax Reform Act of 1984 added §1031(a)(2)(D) which excludes from
nonrecognition treatment exchanges of “interests in a partnership.”
i) Purposes
(1) Exchanges of a partnership interest are akin to exchanges of shares of stock or
other equity interests that are also excluded from nonrecognition treatment
(2) Tax avoidance—Burnt Out Partnership Interests
(a) With the popularity of tax shelter partnership, a partner in a tax shelter who
had depreciated his basis down to nothing, could simply exchange his interest
for an interest in another partnership without recognizing any gain.
b) Methods of Avoiding §1031(a)(2)(D)
i) Tenancy in Common—Election Out of Subchapter K.
(1) A partnership that elects1 out of Subchapter K pursuant to §761(a), is treated as an
interest in the assets of the partnership, not as an interest in the partnership itself.
§1031(2).
(a) Requirements of §761
(i) A partnership can elect out of Subchapter K if it is availed “for investment
purposes only and not for the active conduct of a business” (i.e. an
investment partnership). §761(a)(1).
1. Typically, normal rental activity will not constitute an active trade or
business, but an investment property. See, Rev. Rul. 75-374 (holding
that two person co-ownership of apartment building did not constitute
a partnership where co-owner’s agent collect rent, paid taxes, provided
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The organization can elect out on Form 1065. Treas. Reg. §1.761-2(b)(2)(i). If it fails to do this, it may meet the
requirements of a deemed election if it can be shown that everyone intended to be excluded from Subchapter K.
Treas. Reg. §1.761-2(b)(2)(ii).
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customary services, maintenance, and repair); Rev. Rul. 79-77
(holding that three co-owners of commercial property with net lease
were not a partnership).
(b) Additional Requirements. Rev. Proc. 2002-22
(i) In Rev. Proc. 2002-22, the Service set forth certain guidelines to determine
whether a TIC (or any other undivided fractional interest in rental real
property) would be considered an interest in the property and not an
interest in the partnership.
(ii) Conditions for a Favorable Ruling2. Rev. Proc. 2002-22, Sec. 6.
1. Each co-owner holds title as a tenant in common under local law; title
may not be held by an entity recognized under local law.
2. The number of co-owners must be 35 people or less (but one person
includes a husband and wife).
3. The co-ownership may not file a partnership or corporate tax return,
conduct business under a common name, or otherwise hold itself out
as a partnership.
4. Co-ownership agreement may run with the land
5. Co-owners must retain the right to approve the hiring of any manager,
the sale of the property, any leases of all or a portion of the property,
or the creation or modification of a blanket lien by unanimous consent.
For all other actions, the co-owners can agree to be bound by a
majority 50% vote.
6. Each co-owner must have the right to transfer, partition and encumber
the co-owner’s undivided interest in the property; however, restrictions
can be placed if required by the lender.
7. If the property is sold, the lender must be paid and the remaining
proceeds must be distributed to the co-owners.
8. Each co-owner must share in all profits, expenses and losses
associated with the property in proportion to their undivided interest in
the property.
9. Each co-owner must share in any indebtedness secured by a blanket
lien in proportion to their undivided interests
10. A co-owner may issue an option to purchase their interest, provided
that the option price reflects the FMV.
11. The co-owners activities must be limited to those customarily
performed in connection with the maintenance and repair of rental real
property (“customary activities”. For these purposes, all activities of
all co-owners and their agents will be taken into account.
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It is possible that one or more of these is absent and that the TIC will still be considered an interest in the property.
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12. If there are management or brokerage agreements, they must be
renewable no less than once a year. The fees paid to any manager
must not depend on the income and profits from the property and must
be for FMV.
13. All leases must be bona fide leases at FMV. The rent must not depend
on the income or profits from the property.
14. The lender may not be a related person to any co-owner, the sponsor,
the manager or any lessee of the property.
15. Payments to the sponsor for acquisition of the co-ownership interest
must be FMV and may not depend on the income or profits derived
from the property
(2) Open Issues—TICs as Securities
(a) The SEC has determined that in certain cases, a TIC interest can be a security
for purposes of the securities laws. At the very least, this means that some
TIC offerings (especially to many investors) may have to require with the
securities laws and regulations.
(b) However, under §1031(a)(2)(B), (C) stocks, bonds and “other securities” do
not qualify for nonrecognition treatment. The 1933 Securities Act defines
securities to include “investment” contracts, which under Supreme Court
precedent (SEC v. WJ Howey Co. (1946) 328 U.S. 293), could include TICs
(especially large ones).
(c) The issue, therefore, is whether a TIC classified as a security for purposes
of the securities laws, is also a security for purposes of §1031. Rev. Rul.
2002-22 implicitly suggests that if the TIC meets its requirements that it is
not a security from the Services’ standpoint. This, however, remains an
open issue.
ii) Entities Classified as a Partnership
(1) Problem
(a) But what happens if the entity did not elect out of Subchapter K and some
partners want to cash out, others want to exchange, and other cannot agree on
an exchange property. Rev. Rul. 2002-22 expressly says that the Service
“generally will not issue a [favorable] ruling . . . if the co-owners held
interests in the property through a partnership or corporation immediately
prior to the formation of the co-ownership.” There are several options.
(2) Possible Solutions
(a) “Drop and Swap” and “Swap and Drop”
(i) “Drop and Swap”
1. Here, the partnership makes liquidating distributions of undivided
fractional interests in the property to the partners. Under §731, a
liquidating distribution is generally not a taxable event. After the
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distribution, the partnership ceases to exist, and each of the former
partners own an undivided fractional interest in the property with the
same basis they had before.
2. When the property is sold, each of the partners can either cash out, or
exchange their undivided fractional interest for another property.
(ii) “Swap and Drop”
1. Here, the partnership exchanges the relinquished property for the
replacement property. Since the partnership owns both properties,
there is no §1031(a)(2)(D) problem. After the exchange, the
partnership liquidates and distributes undivided fractional interests in
the property to the partners.
2. Frequently this is employed where the partners cannot agree on a
replacement property. The partnership therefore acquires multiple
properties in the exchange. After they are acquired, the partnership
will distribute one of the properties to a partner in liquidation of his
interest.
a. If this is done, it is generally assumed that the partnership should
not make special allocations of the replacement properties to the
partners (e.g. allocate income and expenses from Blackacre to A
and income and expenses from White acre to B).
(iii)Potential Pitfalls of “Drop and Swap” and “Sway and Drop”
1. Do the former partners satisfy the “held for use in a trade or
business or investment” requirement of §1031?
a. The Service has taken the view that the former partners did not
hold the property for investment, but for the purpose of effecting
an exchange. In so holding, the Services has reasoned that the
holding purposes of the partnership is not attributable to the
partners themselves. See, Rev. Rul. 75-291; Rev. Rul. 77-297;
Rev. Rul. 77-337.
b. The courts—specifically the 9th Circuit—disagree and hold that the
holding purpose of the partnership is attributable to the partners,
and therefore that the former partners meet the “held for” test. See,
Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985); Bolker
v. Commissioner, 760 F.2d 1039 (9th Cir. 1983); Maloney v.
Commissioner 93 T.C. 89 (1989).
i. Most commentators believe this is the better, more reasoned
result, but the issue is far from certain.
2. The new co-owners are still a partnership
a. Even if the partnership liquidates and distributes undivided
fractional shares to the former partners, the new co-owners could
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still be treated as partners because they fail to meet the
requirements of §761 (i.e. it is more than an investment partnership
because the co-owners are active in the management of the
property).
3. Substance over Form
a. If the partnership distributes after it enters into the purchase and
sale agreement, there is a substantial likelihood that the court will
find that the partnership sold the property, notwithstanding the
distribution. Commissioner v. Court Holding Co. (1945) 324 US
331 (holding that corporation that paid liquidating dividend after
entering into purchase agreement was the true seller, not the
former shareholders) (“A sale by one person cannot be transformed
for tax purposes into a sale by another by using the latter as a
conduit through which to pass title.”)
4. Step Transaction Doctrine
a. Under the step transaction doctrine, the transaction is looked at as a
whole, thereby collapsing the “contrived” steps. This was argued
by the IRS and rejected in Magneson, 753 F.3d at 1497. The court
in Bolker did not address the step transaction doctrine.
b. The IRS could argue that the transaction is, in substance, the
acquisition of a partnership interest as replacement property.
(b) Partner Buyout
(i) If one or more partners want to replace the relinquished property with a
particular property, and another partner or partners wants to exchange for
a different property (or wants to cash out), that partner can be bought out
and the partnership can exchange the relinquished property for their
desired replacement property.
(ii) If the partners do not have enough cash to buy that partner out, they can
issue a note to the buyout partner, secured by the relinquished property.
The purchaser of the relinquished property can then satisfy that note as a
part of the consideration for the sale.
1. Note, however, that the purchase price for the replacement property
would have include the amount paid to the departing partner
2. This will only work if there is enough equity in the property so that the
note to the buyout partner will not cause the property to be over
encumbered.
(c) Installment Note Method. §453
(i) Where one or more partners want to replace the relinquished property with
a particular property, and another partner or partners wants to cash out, the
buyer will pay money to the qualified intermediary for purposes of
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purchasing the relinquished property, and will issue an installment note to
“cash out” partners in redemption of their partnership interests.
(ii) As a result, the partnership (with its remaining partners) can exchange the
relinquished property for the replacement property. The cash out partners
will receive cash, which can be deferred into the subsequent tax year
under §453. See, §453(f)(6).
1. Even if the purchaser places all the money into the qualified
intermediary, the qualified intermediary can pay the cash out partners
under the installment method and this will not be considered cash or
cash equivalent for purposes of §453. Treas. Reg. §1.1031(k)-1(j)(2).
(iii)Example
1. A, B and C form a partnership by each contributing $100. The Δ
purchases Blackacre for $300. Blackacre increases in value to $900.
A and B want to exchange Blackacre for Whiteacre, but C wants to
cash out. The Δ sells the property to a buyer for $900, payable $600 in
cash (to the intermediary) and a $300 installment note. The Δ
distributes the note to C in liquidation of his interest under §731. A
and B then exchange Blackacre for Whiteacre and do not receive any
boot.
(iv) Potential Pitfalls
1. The IRS could argue that the installment note is a marketable security
under §731(c), and therefore, could trigger interest charges under
§453A(c). This is a fairly minimal risk.
2. Any depreciation recapture must be recognized in the year of the
actual sale without regard for when the payments are actually made.
§453(i)(1).
(v)
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